Brent Sheather: When layers of fees stack up

Like a fancy wedding cake, some funds have layer upon layer of fees. Photo / Thinkstock

Most times when you read a brokers newsletter or financial planner's good news document you will be told that:

a) Shares, property and everything else is cheap.

b) You need to take on more risk because bank deposits are for fools.

c) We know where the bargains lie, we are here to help you and our products have low fees.

In this "all news is good news" illusory environment it is important that the media try to provide some sort of a balance to the commentary on matters financial.

Accordingly amongst their final articles for 2013 leading writers at the Economist and the London Financial Times respectively put the case for bonds rather than shares and warned that the current environment might be just a bit too euphoric. Time will tell.

Today's column takes a close look at one particular managed fund currently being promoted by a highly respected institution in NZ. No names because we don't like law suits, or business suits for that matter, and it isn't fair to highlight one bad product when there are so many to choose from.

What makes this fund particularly newsworthy is firstly that its investment statement (IS) makes the claim in up to ten places that it is a low cost savings instrument but as we shall see nothing could be further from the truth, so in terms of egregious misinformation this document is up there with the best.

Secondly, despite the efforts of the FMA, the Code of Professional Conduct for financial advisors, the efforts of the Retirement Commissioner, the back slapping blah blah blah the IS doesn't go anywhere near to disclosing the full extent of the fees it will inflict on anyone silly enough to buy it.

"The law as regards disclosure of these other layers can only be described as pathetic as it appears that virtually no disclosure is required. Ridiculous."

Brent Sheather

To be fair however you would need to be a forensic accountant with a spare week up your sleeve to properly calculate the annual charges levied at various levels. What is worse is that the IS implies in a number of places that it has disclosed everything and it took about half an hour of reading to find the one sentence that alluded to, but didn't quantify - two whole new levels of fees.

Anyway, enough of the preamble, let the games begin. We will look at the fund's claims to be low cost and attempt to quantify the total annual fees that unit holders will actually be subject to.

Continued below.

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As previously mentioned the investment statement makes the claim that it is low cost at least ten times using terms like "fair and reasonable fees", "aims to reduce costs", "keeping costs down ", "lower fees", "lower cost structures", "keep costs to a minimum", "cost effective" etc etc. You get the picture..... but the reality is different.

I spent some time looking at each of the second tier of fund managers used and calculated their fees using the latest asset allocation then did the same thing for their performance fees and finally tried to work out the fees charged by the third level of fund managers used in respect of international shares, international bonds and alternative assets.

The total annual fee is estimated at 3.7 per cent pa plus unquantified performance fees paid to the third level of fund managers used. This is despite the investment statement mentioning that the annual management fee is 0.95 per cent and that the Total Expense Ratio was 1.54 per cent.

That ain't low cost. Even the 1.54 per cent tip of the fee iceberg that is disclosed isn't low cost. A low cost fee is the 0.06 per cent charged by an S&P 500 Tracker or the 0.15 per cent levied by an Australian actively managed share fund. The 3.7 per cent estimated annual fee on this fund is some 61.6x the cost of the S&P 500 low cost tracker.

What is also noteworthy is the different layers of fees implicit in this product. For example, in respect of international bonds Mum and Dad pay the unit trust manager 1.54 per cent but they just pass the money to another NZ fund manager who, after taking their annual fee, give the money to an international bond manager who actually does the investing - for another fee of course.

This fee upon fee upon fee structure is replicated in global equities and alternatives and is the reason the total annual fees are so high and so difficult to calculate. The law as regards disclosure of these other layers can only be described as pathetic as it appears that virtually no disclosure is required. Ridiculous.

The other big factor behind the high annual fees is the performance fees that the second, third and, in the case of the alternatives asset class, the fourth tier of fund managers can earn. I wrote "can" earn but because of the way many of the performance fees are determined it would have been more correct to have written "will" earn. For example the biggest asset class in the balanced fund is international shares and one of the sub managers here has used the old favourite technique of comparing the performance of their share fund with a bond benchmark.

Because shares are more risky and frequently outperform bonds benchmarking yourself against bonds almost guarantees nice performance fees without having to outperform the stockmarket. In this case the specifics of the performance arrangement is that the sub manager gets 10 per cent of any gain in the world stockmarket in A$ terms in excess of the 10 year Australian government bond yield.

The numbers in 2013 were 47.8 per cent for the world stockmarket in A$ and the 10 year Australian government bond yield at the end of the year was 4.3 per cent. Ten per cent of the difference is a huge 4.35 per cent fee.

"The conclusion we can draw from the above is that NZ regulators still have an awful lot of work to do before the FMA's vision of "promoting fair, efficient and transparent financial markets that restore and inspire investor confidence" becomes a reality in NZ."

Brent Sheather

The bottom line however is post fee returns so what can we expect long term from this balanced fund of funds of funds pre fees?

With three or even four tiers of brain power working for unit holders we can assume they can do as well as the index before fees, although this could prove to be optimistic. We need to estimate returns to get some perspective on that 3.7 per cent + annual fee.

If returns are likely to be 20 per cent pa who cares about 3.7 per cent? If we estimate returns using the latest asset allocation profile disclosed and long term forecasts for international share markets from non conflicted experts, current yields plus hedging gains for bonds where appropriate and a guess for the alternative component of the portfolio we get forecast returns which are unlikely to exceed 6 per cent pa.

So it is conceivable that after the 3.7 per cent annual fee returns to unit holders will be barely positive.

The conclusion we can draw from the above is that NZ regulators still have an awful lot of work to do before the FMA's vision of "promoting fair, efficient and transparent financial markets that restore and inspire investor confidence" becomes a reality in NZ.